Why Germany May Have A Hard Time Dealing With Deflation

WSJ.com – The ‘Average’ Interest Rate In Euro Zone Helps No One
As far back as September I was suggesting that the solution for Germany’s potential deflation problem is to more deeply integrate itself with the rest of the European Union. This seems counter intuitive at first, but when you consider that monetary policy, and hence, short term interest rates, are controlled by the European Central Bank it starts to make more sense.

Right now the EU has an inflation rate of around 2.1%, but the inflation rate for the individual countries within the EU varies wildly, with Germany under 1%. Clearly, tight monetary policy will do them no favors. In fact, considering that they are the largest economy in the EU, I would be catering to their needs until there is convergance between the European economies and monetary policy can be set based on the EU as a single economy.

“Since no country is average, you’ve ensured that every country has the wrong monetary policy all the time,” says Carl Weinberg, chief economist with High Frequency Economics Ltd., an economics advisory firm in Valhalla, New York. Setting interest rates is “hard, if not impossible, if you set it according to the average in the euro zone.”

A host of factors explains the underperformance of the European economy — which appears on the brink of a recession after Germany, Italy and the Netherlands reported last week that their economic growth shrank in the first quarter, bringing euro-zone growth to a standstill. Most economists expect growth this year for the zone of 1% or less, half the rate expected for the U.S. economy.

Inflexible labor markets, high wages, prohibitive tax rates and regulated markets head the traditional list of so-called structural problems plaguing the European economy. The euro’s rise of recent months — up 10% since November — is also crimping the recovery. The strong euro makes exports less competitive and makes U.S. earnings of European companies less valuable when converted back to euros.

The EU, if they are to make this experiment work, needs to focus on economic convergance soon or the Euro will be a weight around the necks of the individual economies that comprise it.